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S&P 500: Range Contraction May Be Ending - Suggesting A Strong Correction

During extended equity rallies, daily ranges tend to contract. And in the recent past - usually, but not always - larger daily ranges are associated with swift bearish moves.

For the cash S&P 500 index, if this contraction gets to be at or less than 1% of the price of the index (we're now at 1397.00 with the average daily range at 14.00 or so), especially for an extended period of time, then the cash S&P 500 is susceptible to correcting. This has been a very timely heuristic since January 2007. And note that since that time, the one-year historical volatility measurement I use (smoothed with a large simple moving average) has ranged from 10% to 42%.

In this time of risk-on/risk-off trading, the timing of an S&P 500 correction is very important, and so I created an indicator that I call the RCI (Range Contraction Index) by taking an average of the daily range going back n-periods and then dividing by price. (By the way, I'm sure this concept is being used elsewhere in similar ways, but after not finding anything initially, I simply gave it a descriptive name for my own purposes that I'm also using here).

It gives me an idea as to when the S&P 500 is ripe for a strong corrective move.

As a simple filter, I have this indicator first close below 0.9% and then close back above 1.1%.

For the current bullish move, the RCI closed below 0.9% on January 20 and has yet to close back above 1.1%. Currently it's at 1.034%.

When the RCI did meet the above conditions, I highlighted a series of daily cash S&P 500 charts with a vertical line.

In the charts below, these vertical lines appear in the upper panel and in the lower panel, where the RCI is displayed.

(click to enlarge)

Chart 1 of the RCI for cash S&P 500Click to enlarge

(click to enlarge)Chart 2 of the RCI for cash S&P 500Click to enlarge

(click to enlarge)Chart 3 of the RCI for cash S&P 500Click to enlarge

The RCI isn't necessarily a trading signal - it's not always that precise - but a daily close below the 20-day lowest-low (back one day) could be suggested as an entry level.

Prior to 2007, this 1% RCI threshold becomes less effective when one-year S&P 500 volatility levels are below 10%. If the RCI is adjusted for volatility, then it is applicable to not only the S&P 500 on a continuous basis; but also applicable to other markets. For commodities, diminishing ranges can be found nearer to significant lows when prices are basing as opposed to equities and fixed income when daily ranges can diminish nearer to the highs.

My research on the universal applicability is on-going.

But again, given the high correlation that the markets have developed towards the equity market, then this can be a useful indicator unto itself.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.